Although Improvements Have
Been Made, More Can Be Done to Identify Businesses by Their Principal Business
Activity

July 2006

Reference Number:2006-30-097

This
report has cleared the Treasury Inspector General for Tax Administration
disclosure review process and information determined to be restricted from
public release has been redacted from this document.

Phone Number |202-927-7037

Email Address |Bonnie.Heald@tigta.treas.gov

Web Site |http://www.tigta.gov

July 5, 2006

MEMORANDUM FORCOMMISSIONER, WAGE AND
INVESTMENT DIVISION

FROM:Michael
R. Phillips /s/ Michael R. Phillips

Deputy
Inspector General for Audit

SUBJECT:Final Audit Report – Although
Improvements Have Been Made, More Can Be Done to Identify Businesses by Their
Principal Business Activity (Audit # 200430023)

This report presents the results of our review of the Internal
Revenue Service’s (IRS) efforts to identify businesses by their principal business
activity.The overall objective of this
review was to evaluate the effectiveness of the corrective actions taken in
response to the recommendations in a prior Treasury Inspector General for Tax
Administration report.[1]

Synopsis

In the previous report, we recommended management identify
business taxpayers by their principal business activity from information
provided when taxpayers file Applications for Employer Identification Number[2]
(Form SS-4). Early identification by Principal
Business Activity (PBA) code would allow the Internal Revenue Service (IRS) to
include these new businesses in market segment analyses to identify the need
for educational or compliance assistance.

During this review, we found that the IRS has taken steps to
capture the PBA codes during the processing of Forms SS-4; however, many PBA codes
are still not identified during Forms SS-4 processing. Using information supplied by the IRS, the
Social Security Administration now assigns appropriate PBA codes to the
businesses and sends the PBA code information to the IRS.However, limited audit testing determined only
38 percent of PBA codes were recorded on IRS records following the processing of
Forms SS-4.[3]

Also, in the previous report, we recommended management
implement processing controls to identify and correct business income tax
returns with invalid PBA codes and individual income tax returns reporting
business activities with invalid or missing PBA codes.Although the IRS could not take the recommended
corrective actions due to the cost, the procedures for business income tax
returns were improved, which should help to correct invalid PBA codes and add
missing codes.

However, there are still insufficient procedures for
handling both missing and invalid PBA codes on individual income tax returns
reporting business activity. In a test
of 562,807 individual income tax returns with an attached Profit or Loss From
Business (Schedule C), we found 111,790 (20 percent) were processed without PBA
codes.

If missing and invalid PBA codes are not added or corrected,
the IRS may be unable to accurately profile taxpayers by their market segment
for education through outreach programs, identification of nonfilers, and use
in statistical reports and analyses.

Recommendations

The Director, Customer Account Services, Wage and Investment
Division, should 1) coordinate with the Social Security Administration to
determine the causes for missing PBA codes on Forms SS-4 and consider
developing controls and issuing instructions to address the causes identified,
to ensure PBA codes are assigned when required, and 2) develop procedural
instructions to identify and correct individual income tax returns reporting
business activities that have missing or invalid PBA codes.

Response

IRS management
agreed with the first recommendation and determined that some North American
Industry Classification System (NAICS)[4] codes were not transmitted between the agencies.They identified the cause of the problem, and
Social Security Administration and IRS programmers are working to correct the
situation.The IRS will continue to work
with the Social Security Administration to resolve this issue and develop
appropriate validation controls.

However, the IRS disagreed
with our second recommendation.Further,
they stated that they disagreed with one of the basic premises of our report,
that early identification by NAICS codes would allow the IRS to include new
businesses in market segment analyses to identify the need for educational or
compliance assistance, stating that, “while we acknowledge there is the potential to use this information as
you describe, we do not currently use the NAICS codes for this purpose since we
do not communicate directly to the small business taxpayer; instead, we find it
more effective for us to provide education through leveraged liaison and
outreach activities with practitioner organizations and small business and
industry associations.”IRS management considered our
recommendation but determined that implementation would require additional
return processing steps, which would increase the costs and extend the time
required to process applicable individual income tax returns reporting business
activities.This, combined with the fact
that the IRS does not use the NAICS codes to identify and contact small
business taxpayers regarding their possible needs, led to the conclusion that
it is not in the interest of tax administration to implement the recommendation.Management’s complete response to the
draft report is included as Appendix V.

Office of Audit
Comment

We are not advocating that the IRS
communicate directly with the small business taxpayer, and we do not disagree
with the IRS’ use of outreach activities.However, we believe these outreach activities can be more useful if
focused on taxpayer segments with specific, identified needs.For example, we are now completing a review that
identified a significant number of commercial fishermen who could have paid less
tax by taking advantage of a relatively new provision allowing them to average
their income from fishing; however, these taxpayers apparently were unaware of
this provision.We identified these
taxpayers by NAICS code.Therefore, we
believe the IRS should reconsider taking some steps to improve the accuracy of
the NAICS codes.

Copies of
this report are also being sent to the IRS managers affected by the report
recommendations.Please contact me at
(202) 622-6510 if you have questions or Daniel R. Devlin, Assistant Inspector
General for Audit (Small Business and Corporate Programs), at (202) 622-8500.

Principal Business Activity (PBA) codes are used to classify
businesses by type of activity.These
codes were originally based on the Standard Industrial Classification index and
were used exclusively through 1998 by the Internal Revenue Service (IRS). As of 1999, the four-digit Standard Industrial
Classification-based number was changed to a six-digit number based on the
North American Industry Classification System (NAICS), which was developed
through a cooperative effort among the Governments of the United States, Canada,
and Mexico.This System was designed with more than 1,000
codes, approximately 400 of which the IRS has adopted for its use.

In a prior report,[5]
we found the IRS successfully adopted the new NAICS codes; however, the IRS had
not taken advantage of the opportunity to immediately identify taxpayers’ PBA
codes when the taxpayers were first established on the IRS Business Master File
(BMF).[6]Also, processing controls were not
sufficient to ensure valid PBA codes were identified for all business-related
tax returns filed on both the BMF and the Individual Master File.[7]

This review was performed at the IRS Brookhaven, New York,
Campus[8]
during the period March 2005 through March 2006. The audit was conducted in accordance with Government Auditing Standards.Detailed information on our audit objective,
scope, and methodology is presented in Appendix I.Major contributors to the report are listed
in Appendix II.

The IRS cannot identify taxpayers
by industry or market segment until the taxpayers provide valid PBA codes with
the filing of a U.S. Individual Income Tax Return (Form 1040) containing a
Schedule C or F,[9]
a U.S. Return of Partnership Income (Form 1065), or one of the various U.S.
Corporation Income Tax Returns (Form 1120 series). Therefore, newly established businesses cannot
be placed in industries or market segments based on their PBA codes, nor can
they be targeted for prefiling outreach or compliance activities until they
file tax returns with valid PBA codes. With
approximately 2 million Employer Identification Numbers (EIN)[10]
issued annually, this problem affects a great many newly established
businesses.

Although the PBA information was
available, the IRS had not yet taken the opportunity to use it. When taxpayers file an Application for
Employer Identification Number (Form SS-4), their accounts are established on
the IRS Master File.[11]Although the principal business activity is
described on the Form SS-4, taxpayers are not required to enter PBA codes, nor
does the IRS use the taxpayer’s description of the business to identify the
code for entry to the Master File at that time.

We recommended management identify business taxpayers by
their principal business activity from information provided when taxpayers file
Forms SS-4 requesting an EIN and their entities are established on the
BMF.Early identification by PBA code
would allow the IRS to include these new businesses in market segment analyses
to identify the need for educational or compliance assistance.

In their response to the previous report, IRS management
agreed that efforts could be made to identify the PBA codes at the time of
processing Forms SS-4.Management also stated
they would need additional resources to perform the validity and correction
process. The IRS planned to perform a
cost/benefit analysis to make certain the benefits would justify the cost to
perform this work and, ultimately, whether such funding was available.

Changes made since our prior audit include:

Revisions to Form SS-4 - During
the previous audit, Form SS-4, revised in April 2000, instructed taxpayers
to enter, “the exact type of business being operated (for example,
advertising agency, farm, food or beverage establishment, labor union,
real estate agency, steam laundry, rental of coin-operated vending
machine, or investment club).”The current Form SS-4, revised in
December 2001, asks taxpayers to check 1 of 12 boxes which best describes
the principal activity of the applicant’s business.Although the boxes that business
taxpayers are asked to check are limited to only 12 categories, the
instructions continue to ask the applicants to describe their principal
line of business in more detail.

Adoption of New Procedures for
Assigning PBA codes - The IRS now transcribes and electronically transmits
the information from Forms SS-4 to the Social Security Administration,
which then assigns an appropriate PBA code to the business and sends the
PBA code information to the IRS within approximately 2 months.The six-digit codes are then added to
the Master File records for the business entities.

More needs to be done to ensure PBA codes are assigned

In a judgmental sample of Forms SS-4 that consisted of Internet,
fax, and mail-in applications submitted to the IRS during 1 week in August
2004, only 38 percent of PBA codes were recorded on the BMF after the processing
of Forms SS-4 and before the filing of tax returns by businesses that applied for
EINs.[12]

Although the 38 percent represents a significant improvement
from our previous audit, many businesses are still not assigned PBA codes
during Form SS-4 processing.Instead,
PBA codes are not assigned until the businesses file their first tax returns.

The IRS studied alternative methodologies for assigning PBA
codes during Form SS-4 processing and decided not to adopt our recommendations,
primarily due to cost factors.While
actions have been taken to include taxpayers as stakeholders in providing
information on the Form SS-4 concerning their principal business activity and
the Social Security Administration as a stakeholder in assigning PBA codes,
sufficient controls and procedures have not been established to ensure PBA
codes are assigned to taxpayers.

Consequently, the IRS will not receive the full benefit of
more accurate and complete profiling of taxpayers by their market segment for education
of taxpayers through outreach programs, identification of nonfilers, and use in
statistical reports.

Recommendation

Recommendation 1:The Director, Customer Account Services, Wage
and Investment Division, should coordinate with the Social Security
Administration to determine the causes for missing PBA codes on Forms SS-4 and
consider developing controls and issuing instructions to address the causes
identified, to ensure PBA codes are assigned.

Management’s
Response:IRS management agreed with this
recommendation and determined that some NAICS[13] codes were not transmitted between
agencies.They identified the cause of
the problem, and Social Security Administration and IRS programmers are working
to correct the situation.The IRS will
continue to work with the Social Security Administration to resolve this issue
and develop appropriate validation controls.

In our prior report, we recommended management implement
processing controls to identify business income tax returns with invalid PBA
codes and individual income tax returns with invalid or missing PBA codes, for
research and correction during processing.

In response to that report, management stated they would
need additional resources to perform the validity and correction process. A cost/benefit analysis would be performed to
make certain the benefits would justify the cost to perform this work and,
ultimately, whether such funding was available. In its analysis, the IRS would consider any
impact that might delay the processing of returns, thus adversely affecting
customer service.

PBA code processing - business
income tax returns

Although the IRS could not take the recommended corrective
actions due to the cost, procedures were improved to correct invalid PBA codes
and add missing codes for business tax returns.

Procedures regardingPBA codeswere added to the Internal Revenue Manual covering
the processing of business returns.When
codes are missing or invalid, tax examiners are now instructed to use the
information on the returns and the list of PBA codes to determine what the code
should be.If they are unable to make a
determination, a generic code is used.

PBA code processing - individual
income tax returns

In the prior audit, we reported the IRS did not have
sufficient controls for handling both missing and invalid PBA codes on
individual income tax returns and there were no Internal Revenue Manual
instructions to identify and correct the PBA codes. Specifically, we reported that:

Approximately 2 million individual income
tax returns containing Schedules C or F were processed with missing codes. This represented 9.6 percent of all tax
returns filed with these Schedules. Just over 780,000 individual income tax returns
with Schedules C or F were processed with invalid codes. This represented 3.7 percent of all tax
returns filed with these Schedules.

Although Internal Revenue Manual instructions were developed
to address and correct invalid PBA codes on business income tax returns,
management has not addressed missing and invalid PBA codes on individual income
tax returns reporting business activities.The procedural changes adopted for processing business returns should
also be adopted for processing individual income tax returns. This should help ensure missing PBA codes are
added and invalid codes are corrected on individual income tax returns
reporting business activity.

Filing instructions for tax returns with attached an Schedule
C and/or Schedule F require PBA codes.Our
audit test showed that approximately 20 percent of individual income tax returns
with an attached Schedule C did not have PBA codes.Using a computer application, we identified
562,807 returns filed with a Schedule C for Tax Year 2003 and found 111,790
were processed without PBA codes.

If these missing and invalid PBA codes are not added or
corrected, the IRS may be unable to accurately profile taxpayers by their
market segment for education through outreach programs and use in statistical
reports and analyses.

Management’s
Response:IRS management disagreed with
this recommendation.Further, they
stated that they disagreed with one of the basic premises of our report, that early
identification by NAICS codes would allow the IRS to include new businesses in
market segment analyses to identify the need for educational or compliance
assistance, stating that, “while
we acknowledge there is the potential to use this information as you describe,
we do not currently use the NAICS codes for this purpose since we do not
communicate directly to the small business taxpayer; instead, we find it more
effective for us to provide education through leveraged liaison and outreach
activities with practitioner organizations and small business and industry
associations.”IRS
management stated they considered our recommendation but determined implementing
it would require additional return processing steps, which would increase the
costs and extend the time required to process applicable individual income tax
returns reporting business activities.This, combined with the fact that the IRS does not use the NAICS codes
to identify and contact small business taxpayers regarding their possible
needs, led to the conclusion that it is not in the interest of tax
administration to implement the recommendation.

Office of Audit Comment:We are not advocating that the IRS communicate
directly with the small business taxpayer, and we do not disagree with the IRS’
use of outreach activities.However, we
believe these outreach activities can be more useful if focused on taxpayer
segments with specific, identified needs.For example, we are now completing a review that identified a
significant number of commercial fishermen who could have paid less tax by
taking advantage of a relatively new provision allowing them to average their
income from fishing; however, these taxpayers apparently were unaware of this
provision.We identified these taxpayers
by NAICS code.Therefore, we believe the
IRS should reconsider taking some steps to improve the accuracy of the NAICS
codes.

The overall objective of this review was to evaluate the
effectiveness of the corrective actions taken in response to the
recommendations in a prior Treasury Inspector General for Tax Administration (TIGTA)
report.[14]To accomplish this objective, we:

I.Determined whether corrective measures were taken by
the Internal Revenue Service (IRS).We
reviewed management’s response to the original report to identify which
findings required corrective actions and how the corrective actions were to be
implemented. We also determined what
corrective actions had been implemented.

II.Evaluated the adequacy and effectiveness of corrective actions
taken.

A.Determined
whether processing instructions involving the Application for Employer
Identification Number (Form SS-4) were adequate and/or updated to ensure Principal
Business Activity (PBA) codes were established when business entities were
created by Form SS-4 filings.We reviewed
a judgmental sample[15]
of 315 Forms SS-4 processed at the IRS Brookhaven, New York, Campus[16]
and researched IRS records to determine whether PBA codes were assigned to the
businesses.For 1 week in August 2004,
198 Employer Identification Number (EIN)[17]
applications selected were initiated through the Internet, 103 EIN applications
selected were Forms SS-4 faxed to the Brookhaven Campus, 6 EIN applications selected
were submitted with correspondence, and 8 EIN applications selected were received
in the mail. We also evaluated the
cost/benefit analysis performed regarding establishing PBA codes at the time of
Form SS-4 filing.

B.Determined
whether processing instructions for resolving missing or invalid PBA codes on
business and individual income tax returns were adequate and/or updated.Using a computer application, we extracted
from the TIGTA Data Center Warehouse,[18]
as of July 20, 2005, 562,807 Tax Year 2003 individual income tax returns, with an
attached Profit or Loss From Business (Schedule C). We analyzed the file and determined the number
and percentage of returns processed without PBA codes.

III.Determined, where substantive corrective actions had
not been taken, if there were corrective actions that could be taken to improve
the processing of PBA codes.We also
interviewed program analysts to determine whether there were less costly
corrective actions that could be taken.

This appendix presents detailed information on the
measurable impact that our recommended corrective actions will have on tax
administration.This benefit will be
incorporated into our Semiannual Report to Congress.

Our audit test showed that approximately 20 percent of individual
income tax returns with an attached Profit or Loss From Business (Schedule C) did
not have Principal Business Activity codes.Using a computer application, we identified 562,807 returns filed with a
Schedule C for Tax Year 2003 and found 111,790 were processed without Principal
Business Activity codes.

The response was removed due to its
size.To see the response, please go to
the Adobe PDF version of the report on the TIGTA Public Web Page.

[1]Additional Controls Are Necessary to Ensure
that All Businesses are Classified by Their Principal Business Activity (Reference
Number 2001-30-117, dated August 2001).

[2] The
Employer Identification Number is a unique nine-digit number used to identify a
taxpayer’s business account.

[3] We
sampled 315 Form SS-4 applications that were selected at the Brookhaven, New York, IRS Campus for
1 week in August 2004.Ninety-seven of
the 315 Forms SS-4 did not require a PBA code; the remaining 218 did require a
code.Of the 218 Forms SS-4 requiring
PBA codes, only 38 percent (82 of 218) had PBA codes entered on IRS
records.The campuses are the data
processing arm of the IRS.They process
paper and electronic submissions, correct errors, and forward data to the
Computing Centers for analysis and posting to taxpayer accounts.

[4]
According to the IRS’ response to our draft report (see Appendix V), the PBA
codes are now known as NAICS codes, and the IRS response uses that abbreviation
in place of “PBA.”

[5]Additional Controls Are Necessary to Ensure
that All Businesses Are Classified by Their Principal Business Activity
(Reference Number 2001-30-117, dated August 2001).

[6] The IRS
database that consists of Federal tax-related transactions and accounts for
businesses.These include employment taxes,
income taxes on businesses, and excise taxes.

[7] The IRS
database that maintains transactions or records of individual tax accounts.

[8] The
campuses are the data processing arm of the IRS.They process paper and electronic
submissions, correct errors, and forward data to the Computing Centers for
analysis and posting to taxpayer accounts.

[9] The
Schedules are Profit or Loss From Business (Schedule C) and Profit or Loss From
Farming (Schedule F).

[10] A
unique nine-digit number used to identify a taxpayer’s business account.

[11] The IRS
database that stores various types of taxpayer account information.This database includes individual, business,
and employee plans and exempt organizations data.

[12] We sampled 315 Form SS-4 applications that were
selected at the IRS Brookhaven Campus.Ninety-seven
of the 315 Forms SS-4 did not require a PBA code; the remaining 218 did require
a code.Of the 218 Forms SS-4 requiring
PBA codes, only 38 percent (82 of 218) had PBA codes recorded on the BMF.

[13]
According to the IRS’ response to our draft report (see Appendix V), the PBA
codes are now known as NAICS codes, and the IRS response uses that abbreviation
in place of “PBA.”

[14]Additional Controls Are Necessary to Ensure
that All Businesses are Classified by Their Principal Business Activity (Reference
Number 2001-30-117, dated August 2001).

[15] A
judgmental sample was selected because the Forms SS-4 are available for a
limited time only.The IRS processed
approximately 3.5 million Forms SS-4 during 2004, but the Forms are generally
available only when they were being processed.

[16] The
campuses are the data processing arm of the IRS.They process paper and electronic
submissions, correct errors, and forward data to the Computing Centers for
analysis and posting to taxpayer accounts.

[17] A
unique nine-digit number used to identify a taxpayer’s business account.

[18] The
Warehouse is a centralized data storage facility that TIGTA auditors use to
obtain IRS data.